Practice Note 31 in the spotlight

April 12, 2017

The deductibility of interest for income tax purposes recently came under scrutiny in Mr X v CSARS,[1] and specifically the application of SARS’ Practice Note 31. As a general rule, expenditure would be deductible for income tax purposes if it meets all of the requirements in section 11(a) of the Income Tax Act, 58 of 1962:

“For the purpose of determining the taxable income derived by any person from carrying on any trade, there shall be allowed as deductions from the income of such person so derived … expenditure and losses actually incurred in the production of the income, provided such expenditure and losses are not of a capital nature…”

Of particular emphasis in the judgment referred to was whether interest in question was incurred:

i)for the purposes of trade; and

ii)in the production of income.

The taxpayer, Mr X, was a director at a law firm since 2004 and advanced funds periodically to that firm to shore up its working capital reserves. On this loan account Mr X earned interest. At about the same time Mr X also purchased a house in Constantia and funded the purchase price by registering a mortgage bond over the property as security for a loan taken out with a local bank. This bank loan carried interest, and it is the deductibility of this interest that was in dispute.

The taxpayer sought to rely primarily on the provisions of Practice Note 31 to allow him to deduct the interest paid from the interest earned. Consensus existed between the parties that the Practice Note operates to deem interest paid to be for the purposes of trade, limited to the extent to which that the taxpayer in question would have earned interest income. Since Mr X limited the interest deductions claimed to the interest earned on his personal loan account, it appears to be undisputed that the interest paid on the home loan was to be treated as though it was incurred for purposes of trade in accordance with Practice Note 31 (even if technically speaking this was not the case).

What was in dispute though was whether the interest incurred towards the bank can be said to have been in the production of income, being the interest earned on the loan to Mr X’s employer. Mr X sought to put up various arguments why there was a sufficiently close link between the interest paid and the interest earned, primary among these being that had he not been required to advance loan funding to his employer he would have utilised such funds to repay part of his home loan and thus to reduce his interest expenditure.

In the end though and based on the facts, the court found against Mr X and thus held that the interest incurred was not in the production of the interest income on Mr X’s loan account, and therefore not deductible for income tax purposes. Of importance though is also the court’s finding that even though Practice Note 31 may very well deem interest paid to have been for the purposes of trade (to the extent that a comparative amount of interest is also earned), however this does not extend to the requirement that the interest be incurred in the production of income. Practice Note 31 does not address this requirement and taxpayers are still required to show a causal link between interest paid and interest earn to qualify it to be deducted for income tax purposes, even if a comparative amount of interest is also earned.

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors & omissions excepted. (E&OE).